5. Derivative Financial Instruments

Derivatives are generally used to hedge or reduce exposure to market risks associated with assets held or expected to be purchased or sold and liabilities incurred or expected to be incurred. Derivatives are used to change the characteristics of our asset/liability mix consistent with our risk management activities. Derivatives are also used in asset replication strategies.

Types of Derivative Instruments

Interest Rate Contracts

Interest rate risk is the risk we will incur economic losses due to adverse changes in interest rates. Sources of interest rate risk include the difference between the maturity and interest rate changes of assets with the liabilities they support, timing differences between the pricing of liabilities and the purchase or procurement of assets and changing cash flow profiles from original projections due to prepayment options embedded within asset and liability contracts. We use various derivatives to manage our exposure to fluctuations in interest rates.

Interest rate swaps are contracts in which we agree with other parties to exchange, at specified intervals, the difference between fixed rate and/or floating rate interest amounts based upon designated market rates or rate indices and an agreed upon notional principal amount. Generally, no cash is exchanged at the outset of the contract and no principal payments are made by any party. Cash is paid or received based on the terms of the swap. We use interest rate swaps primarily to more closely match the interest rate characteristics of assets and liabilities and to mitigate the risks arising from timing mismatches between assets and liabilities (including duration mismatches). We also use interest rate swaps to hedge against changes in the value of assets we anticipate acquiring and other anticipated transactions and commitments. Interest rate swaps are used to hedge against changes in the value of the guaranteed minimum withdrawal benefit (“GMWB”) liability. The GMWB rider on our variable annuity products provides for guaranteed minimum withdrawal benefits regardless of the actual performance of various equity and/or fixed income funds available with the product.

Interest rate options, including interest rate caps and interest rate floors, which can be combined to form interest rate collars, are contracts that entitle the purchaser to pay or receive the amounts, if any, by which a specified market rate exceeds a cap strike interest rate, or falls below a floor strike interest rate, respectively, at specified dates. We use interest rate options to manage prepayment risks in our assets and minimum guaranteed interest rates and lapse risks in our liabilities.

A swaption is an option to enter into an interest rate swap at a future date. We have purchased swaptions to offset or modify existing exposures. Swaptions provide us the benefit of the agreed-upon strike rate if the market rates for liabilities are higher, with the flexibility to enter into the current market rate swap if the market rates for liabilities are lower. Swaptions not only hedge against the downside risk, but also allow us to take advantage of any upside benefits.

In exchange‑traded futures transactions, we agree to purchase or sell a specified number of contracts, the values of which are determined by the values of designated classes of securities, and to post variation margin on a daily basis in an amount equal to the difference in the daily market values of those contracts. We enter into exchange‑traded futures with regulated futures commissions merchants who are members of a trading exchange. We have used exchange‑traded futures to reduce market risks from changes in interest rates and to alter mismatches between the assets in a portfolio and the liabilities supported by those assets.

Foreign Exchange Contracts

Foreign currency risk is the risk we will incur economic losses due to adverse fluctuations in foreign currency exchange rates. This risk arises from foreign currency‑denominated funding agreements issued to nonqualified institutional investors in the international market, foreign currency‑denominated fixed maturity and equity securities, and our international operations, including expected cash flows and potential acquisition and divestiture activity. We use various derivatives to manage our exposure to fluctuations in foreign currency exchange rates.

Currency swaps are contracts in which we agree with other parties to exchange, at specified intervals, a series of principal and interest payments in one currency for that of another currency. Generally, the principal amount of each currency is exchanged at the beginning and termination of the currency swap by each party. The interest payments are primarily fixed-to-fixed rate; however, they may also be fixed-to-floating rate or floating-to-fixed rate. These transactions are entered into pursuant to master agreements that provide for a single net payment to be made by one counterparty for payments made in the same currency at each due date. We use currency swaps to reduce market risks from changes in currency exchange rates with respect to investments or liabilities denominated in foreign currencies that we either hold or intend to acquire or sell.

Currency forwards are contracts in which we agree with other parties to deliver or receive a specified amount of an identified currency at a specified future date. Typically, the price is agreed upon at the time of the contract and payment for such a contract is made at the specified future date. We use currency forwards to reduce market risks from changes in currency exchange rates with respect to investments or liabilities denominated in foreign currencies that we either hold or intend to acquire or sell. We sometimes use currency forwards to hedge the currency risk associated with a business combination or to hedge certain net equity investments in or expected cash flows from our foreign operations.

Currency options are contracts that give the holder the right, but not the obligation to buy or sell a specified amount of the identified currency within a limited period of time at a contracted price. The contracts are net settled in cash, based on the differential in the current foreign exchange rate and the strike price. Purchased and sold options can be combined to form a foreign currency collar where we receive a payment if the foreign exchange rate is below the purchased option strike price and make a payment if the foreign exchange rate is above the sold option strike price. We use currency options to hedge expected cash flows from our foreign operations.

Equity Contracts

Equity risk is the risk that we will incur economic losses due to adverse fluctuations in common stock prices. We use various derivatives to manage our exposure to equity risk, which arises from products in which the interest we credit is tied to an external equity index as well as products subject to minimum contractual guarantees.

We purchase equity call spreads (“option collars”) to hedge the equity participation rates promised to contractholders in conjunction with our fixed deferred annuity and universal life products that credit interest based on changes in an external equity index. We use exchange-traded futures and equity put options to hedge against changes in the value of the GMWB liability related to the GMWB rider on our variable annuity product. The premium associated with certain options is paid quarterly over the life of the option contract.

Credit Contracts

Credit risk relates to the uncertainty associated with the continued ability of a given obligor to make timely payments of principal and interest. We use credit default swaps to enhance the return on our investment portfolio by providing comparable exposure to fixed income securities that might not be available in the primary market. They are also used to hedge credit exposures in our investment portfolio. Credit derivatives are used to sell or buy credit protection on an identified name or names on an unfunded or synthetic basis in return for receiving or paying a quarterly premium. The premium generally corresponds to a referenced name's credit spread at the time the agreement is executed. In cases where we sell protection, we also buy a quality cash bond to match against the credit default swap, thereby entering into a synthetic transaction replicating a cash security. When selling protection, if there is an event of default by the referenced name, as defined by the agreement, we are obligated to pay the counterparty the referenced amount of the contract and receive in return the referenced security in a principal amount equal to the notional value of the credit default swap.

Total return swaps are contracts in which we agree with other parties to exchange, at specified intervals, an amount determined by the difference between the previous price and the current price of a reference asset based upon an agreed upon notional principal amount plus an additional amount determined by the financing spread. We have used futures traded on an exchange (“exchange-traded”) and total return swaps referencing equity indices to hedge our portfolio from potential credit losses related to systemic events.

Other Contracts

Embedded Derivatives. We purchase or issue certain financial instruments or products that contain a derivative instrument that is embedded in the financial instrument or product. When it is determined that the embedded derivative possesses economic characteristics that are not clearly or closely related to the economic characteristics of the host contract and a separate instrument with the same terms would qualify as a derivative instrument, the embedded derivative is bifurcated from the host instrument for measurement purposes. The embedded derivative, which is reported with the host instrument in the consolidated statements of financial position, is carried at fair value.

We had investment contracts in which the return was tied to a leveraged inflation index. We economically hedged the risk associated with these investment contracts.

We offer group annuity contracts that have guaranteed separate accounts as an investment option. We also offer funds with embedded fixed-rate guarantees as investment options in our defined contribution plans in Hong Kong.

We have structured investment relationships with trusts we have determined to be VIEs, which are consolidated in our financial statements. The notes issued by these trusts include obligations to deliver an underlying security to residual interest holders and the obligations contain an embedded derivative of the forecasted transaction to deliver the underlying security.

We have fixed deferred annuities and universal life products that credit interest based on changes in an external equity index. We also have certain variable annuity products with a GMWB rider, which allows the customer to make withdrawals of a specified annual amount, either for a fixed number of years or for the lifetime of the customer, even if the account value is fully exhausted. Declines in the equity markets may increase our exposure to benefits under contracts with the GMWB. We economically hedge the exposure in these contracts, as previously explained.

Exposure

Our risk of loss is typically limited to the fair value of our derivative instruments and not to the notional or contractual amounts of these derivatives. We are also exposed to credit losses in the event of nonperformance of the counterparties. Our current credit exposure is limited to the value of derivatives that have become favorable to us. This credit risk is minimized by purchasing such agreements from financial institutions with high credit ratings and by establishing and monitoring exposure limits. We also utilize various credit enhancements, including collateral and credit triggers to reduce the credit exposure to our derivative instruments.

Derivatives may be exchange-traded or they may be privately negotiated contracts, which are usually referred to as over-the-counter (“OTC”) derivatives. Certain of our OTC derivatives are cleared and settled through central clearing counterparties (“OTC cleared”), while others are bilateral contracts between two counterparties (“bilateral OTC”). Our derivative transactions are generally documented under International Swaps and Derivatives Association, Inc. (“ISDA”) Master Agreements. Management believes that such agreements provide for legally enforceable set-off and close-out netting of exposures to specific counterparties. Under such agreements, in connection with an early termination of a transaction, we are permitted to set off our receivable from a counterparty against our payables to the same counterparty arising out of all included transactions. For reporting purposes, we do not offset fair value amounts of bilateral OTC derivatives for the right to reclaim cash collateral or the obligation to return cash collateral against fair value amounts recognized for derivative instruments executed with the same counterparties under master netting agreements. OTC cleared derivatives have variation margin that is legally characterized as settlement of the derivative exposure, which reduces their fair value in the consolidated statements of financial position.

We posted $106.6 million and $195.0 million in cash and securities under collateral arrangements as of December 31, 2018 and December 31, 2017, respectively, to satisfy collateral and initial margin requirements associated with our derivative credit support agreements and FCM agreements.

Certain of our derivative instruments contain provisions that require us to maintain an investment grade rating from each of the major credit rating agencies on our debt. If the ratings on our debt were to fall below investment grade, it would be in violation of these provisions and the counterparties to the derivative instruments could request immediate payment or demand immediate and ongoing full overnight collateralization on derivative instruments in net liability positions. The aggregate fair value, inclusive of accrued interest, of all derivative instruments with credit-risk-related contingent features that were in a liability position without regard to netting under derivative credit support annex agreements as of December 31, 2018 and December 31, 2017, was $109.7 million and $280.4 million, respectively. Cleared derivatives have contingent features that require us to post excess margin as required by the FCM. The terms surrounding excess margin vary by FCM agreement. With respect to derivatives containing collateral triggers, we posted collateral and initial margin of $106.6 million and $195.0 million as of December 31, 2018 and December 31, 2017, respectively, in the normal course of business, which reflects netting under derivative agreements. If the credit-risk-related contingent features underlying these agreements were triggered on December 31, 2018, we would be required to post an additional $28.9 million of collateral to our counterparties.

As of December 31, 2018 and December 31, 2017, we had received $79.5 million and $124.7 million, respectively, of cash collateral associated with our derivative credit support annex agreements and FCM agreements, for which we recorded a corresponding liability reflecting our obligation to return the collateral.

Notional amounts are used to express the extent of our involvement in derivative transactions and represent a standard measurement of the volume of our derivative activity. Notional amounts represent those amounts used to calculate contractual flows to be exchanged and are not paid or received, except for contracts such as currency swaps. Credit exposure represents the gross amount owed to us under derivative contracts as of the valuation date. The notional amounts and credit exposure of our derivative financial instruments by type were as follows:


	December 31, 2018		December 31, 2017
	(in millions)
Notional amounts of derivative instruments
Interest rate contracts:
Interest rate swaps	$	34,393.7	$	23,543.4
Interest rate options		1,126.9		657.0
Interest rate futures		260.0		236.5
Swaptions		—		14.0
Foreign exchange contracts:
Currency swaps		898.6		888.6
Currency forwards		863.6		915.5
Currency options		525.2		583.6
Equity contracts:
Equity options		1,522.5		3,649.4
Equity futures		491.7		357.8
Credit contracts:
Credit default swaps		420.0		668.5
Other contracts:
Embedded derivatives		9,452.3		9,402.3
Total notional amounts at end of period	$	49,954.5	$	40,916.6
Credit exposure of derivative instruments
Interest rate contracts:
Interest rate swaps	$	95.4	$	163.4
Interest rate options		16.3		19.8
Foreign exchange contracts:
Currency swaps		71.2		79.1
Currency forwards		2.8		24.3
Currency options		1.9		1.6
Equity contracts:
Equity options		7.7		18.2
Credit contracts:
Credit default swaps		2.4		5.0
Total gross credit exposure		197.7		311.4
Less: collateral received		122.9		159.7
Net credit exposure	$	74.8	$	151.7

The fair value of our derivative instruments classified as assets and liabilities was as follows:


	Derivative assets (1)				Derivative liabilities (2)
	December 31, 2018		December 31, 2017		December 31, 2018		December 31, 2017
	(in millions)
Derivatives designated as hedging instruments
Interest rate contracts	$	—	$	—	$	16.1	$	22.9
Foreign exchange contracts		37.6		39.6		13.5		36.3
Total derivatives designated as hedging instruments	$	37.6	$	39.6	$	29.6	$	59.2
Derivatives not designated as hedging instruments
Interest rate contracts	$	108.0	$	175.2	$	22.6	$	33.6
Foreign exchange contracts		38.4		66.2		72.9		26.3
Equity contracts		7.7		18.2		27.6		154.1
Credit contracts		2.3		4.8		4.4		1.5
Other contracts		—		—		134.6		413.4
Total derivatives not designated as hedging instruments		156.4		264.4		262.1		628.9
Total derivative instruments	$	194.0	$	304.0	$	291.7	$	688.1

(1)

The fair value of derivative assets is reported with other investments on the consolidated statements of financial position.

(2)

The fair value of derivative liabilities is reported with other liabilities on the consolidated statements of financial position, with the exception of certain embedded derivative liabilities. Embedded derivatives with a net liability fair value of $45.2 million and $160.3 million as of December 31, 2018 and December 31, 2017, respectively, are reported with contractholder funds on the consolidated statements of financial position.

Credit Derivatives Sold

When we sell credit protection, we are exposed to the underlying credit risk similar to purchasing a fixed maturity security instrument. Our credit derivative contracts sold reference a single name or reference security (referred to as “single name credit default swaps”). These instruments are either referenced in an OTC credit derivative transaction or embedded within an investment structure that has been fully consolidated into our financial statements.

These credit derivative transactions are subject to events of default defined within the terms of the contract, which normally consist of bankruptcy, failure to pay, or modified restructuring of the reference entity and/or issue. If a default event occurs for a reference name or security, we are obligated to pay the counterparty an amount equal to the notional amount of the credit derivative transaction. As a result, our maximum future payment is equal to the notional amount of the credit derivative. In certain cases, we also may have purchased credit protection with identical underlyings to certain of our sold protection transactions. As of December 31, 2018 and December 31, 2017, we did not purchase credit protection relating to our sold protection transactions. In certain circumstances, our potential loss could also be reduced by any amount recovered in the default proceedings of the underlying credit name.

The following tables show our credit default swap protection sold by types of contract, types of referenced/underlying asset class and external agency rating for the underlying reference security. The maximum future payments are undiscounted and have not been reduced by the effect of any offsetting transactions, collateral or recourse features described above.


	December 31, 2018
							Weighted
					Maximum		average
	Notional		Fair		future		expected life
	amount		value		payments		(in years)
	(in millions)

Single name credit default swaps
Corporate debt
AAA	$	10.0	$	0.1	$	10.0	0.7
A		15.0		0.1		15.0	1.0
BBB		190.0		0.4		190.0	1.7
BB		10.0		—		10.0	0.5
CCC		15.0		(3.6)		15.0	0.9
Government/municipalities
AA		20.0		0.2		20.0	1.0
Sovereign
A		10.0		0.1		10.0	0.7
BBB		55.0		0.4		55.0	1.3
Total credit default swap protection sold	$	325.0	$	(2.3)	$	325.0	1.4


	December 31, 2017
							Weighted
					Maximum		average
	Notional		Fair		future		expected life
	amount		value		payments		(in years)
	(in millions)
Single name credit default swaps
Corporate debt
AAA	$	30.0	$	0.3	$	30.0	1.2
AA		30.0		0.1		30.0	0.5
A		105.0		0.5		105.0	0.6
BBB		255.0		2.5		255.0	1.3
B		20.0		(0.5)		20.0	1.8
Government/municipalities
AA		20.0		0.3		20.0	2.0
Sovereign
A		10.0		0.2		10.0	1.7
BBB		55.0		0.8		55.0	2.3
Total credit default swap protection sold	$	525.0	$	4.2	$	525.0	1.3

Fair Value Hedges

We use fixed-to-floating rate interest rate swaps to more closely align the interest rate characteristics of certain assets and have used them to align the interest rate characteristics of certain liabilities. In general, these swaps are used in asset and liability management to modify duration, which is a measure of sensitivity to interest rate changes.

The net interest effect of interest rate swap transactions for derivatives in fair value hedges is recorded as an adjustment to income or expense of the underlying hedged item in our consolidated statements of operations.

Hedge effectiveness testing for fair value relationships is performed utilizing a regression analysis approach for both prospective and retrospective evaluations. This regression analysis will consider multiple data points for the assessment that the hedge continues to be highly effective in achieving offsetting changes in fair value. In certain periods, the comparison of the change in value of the derivative and the change in the value of the hedged item may not be offsetting at a specific period in time due to small movements in value. However, any amounts recorded as fair value hedges have shown to be highly effective in achieving offsetting changes in fair value both for present and future periods.

The following table shows the effect of derivatives in fair value hedging relationships and the related hedged items on the consolidated statements of operations. All gains or losses on derivatives were included in the assessment of hedge effectiveness.


	Amount of gain (loss)							Amount of gain (loss)
	recognized in net income on							recognized in net income on
	derivatives for the year ended						Hedged items in fair	related hedged item for the year ended
Derivatives in fair value	December 31, (1)						value hedging	December 31, (1)
hedging relationships	2018		2017		2016		relationships	2018		2017		2016
	(in millions)							(in millions)
Interest rate contracts	$	6.2	$	4.7	$	19.5	Fixed maturities, available-for-sale	$	(6.6)	$	(5.2)	$	(19.2)
Interest rate contracts		—		(0.6)		(0.9)	Investment contracts		—		0.6		1.0
Total	$	6.2	$	4.1	$	18.6	Total	$	(6.6)	$	(4.6)	$	(18.2)

(1)

The gain (loss) on both derivatives and hedged items in fair value relationships is reported in net realized capital gains (losses) on the consolidated statements of operations. The net amount represents the ineffective portion of our fair value hedges.

The following table shows the periodic settlements on interest rate contracts and foreign exchange contracts in fair value hedging relationships.


	Amount of gain (loss) for the
	year ended December 31,
Hedged item	2018		2017		2016
	(in millions)
Fixed maturities, available-for-sale (1)	$	(5.9)	$	(10.3)	$	(41.9)
Investment contracts (2)		—		0.9		2.6

(1)Reported in net investment income on the consolidated statements of operations.

(2)Reported in benefits, claims and settlement expenses on the consolidated statements of operations.

Cash Flow Hedges

We utilized floating-to-fixed rate interest rate swaps to eliminate the variability in cash flows of recognized financial assets and liabilities and forecasted transactions.

We enter into currency exchange swap agreements to convert both principal and interest payments of certain foreign denominated assets and liabilities into U.S. dollar denominated fixed-rate instruments to eliminate the exposure to future currency volatility on those items.

The net interest effect of interest rate swap and currency swap transactions for derivatives in cash flow hedges is recorded as an adjustment to income or expense of the underlying hedged item in our consolidated statements of operations.

The maximum length of time we are hedging our exposure to the variability in future cash flows for forecasted transactions, excluding those related to the payments of variable interest on existing financial assets and liabilities, is 1.5 years. As of December 31, 2018, we had $0.0 million of net gains reported in AOCI on the consolidated statements of financial position related to active hedges of forecasted transactions. If a hedged forecasted transaction is no longer probable of occurring, cash flow hedge accounting is discontinued. If it is probable that the hedged forecasted transaction will not occur, the deferred gain or loss is immediately reclassified from AOCI into net income. We reclassified $0.3 million and $0.2 million from AOCI into net realized capital gains (losses) as a result of the determination that hedged cash flows were probable of not occurring during 2018 and 2017, respectively.

The following table shows the effect of derivatives in cash flow hedging relationships on the consolidated statements of operations and consolidated statements of financial position. All gains or losses on derivatives were included in the assessment of hedge effectiveness.


		Amount of gain (loss)							Amount of gain (loss)
		recognized in AOCI on							reclassified from AOCI on
		derivatives (effective portion)						Location of gain (loss)	derivatives (effective portion)
		for the year ended						reclassified from	for the year ended
Derivatives in cash flow	Related	December 31,						AOCI into net income	December 31,
hedging relationships	hedged item	2018		2017		2016		(effective portion)	2018		2017		2016
		(in millions)							(in millions)
Interest rate contracts	Fixed maturities, available-for-sale	$	36.7	$	(51.7)	$	(33.1)	Net investment income	$	20.9	$	21.0	$	19.3
								Net realized capital gains (losses)		17.0		(0.6)		11.2
Interest rate contracts	Investment contracts		—		—		1.6	Benefits, claims and settlement expenses		(0.1)		—		—
Interest rate contracts	Debt		—		—		—	Operating expense		(10.7)		(10.8)		(9.2)
Foreign exchange contracts	Fixed maturities, available-for-sale		20.8		(68.5)		4.0	Net realized capital gains		12.7		22.0		6.4
Foreign exchange contracts	Investment contracts		(0.1)		—		6.0	Benefits, claims and settlement expenses		—		—		—
Total		$	57.4	$	(120.2)	$	(21.5)	Total	$	39.8	$	31.6	$	27.7

The following table shows the periodic settlements on interest rate contracts and foreign exchange contracts in cash flow hedging relationships.


	Amount of gain (loss) for the
	year ended December 31,
Hedged item	2018		2017		2016
	(in millions)
Fixed maturities, available-for-sale (1)	$	6.0	$	7.1	$	5.8
Investment contracts (2)		(0.1)		(1.1)		(15.7)

(1)

Reported in net investment income on the consolidated statements of operations.

(2)

Reported in benefits, claims and settlement expenses on the consolidated statements of operations.

The ineffective portion of our cash flow hedges is reported in net realized capital gains (losses) on the consolidated statements of operations. The net gain (loss) resulting from the ineffective portion of derivatives in cash flow hedging relationships was insignificant for the years ended December 31, 2018, 2017 and 2016.

We expect to reclassify net gains of $20.8 million from AOCI into net income in the next 12 months, which includes both net deferred gains on discontinued hedges and net losses on periodic settlements of active hedges. Actual amounts may vary from this amount as a result of market conditions.

Derivatives Not Designated as Hedging Instruments

Our use of futures, certain swaptions and swaps, option collars, options and forwards are effective from an economic standpoint, but they have not been designated as hedges for financial reporting purposes. As such, periodic changes in the market value of these instruments, which includes mark-to-market gains and losses as well as periodic and final settlements, primarily flow directly into net realized capital gains (losses) on the consolidated statements of operations.

The following table shows the effect of derivatives not designated as hedging instruments, including fair value changes of embedded derivatives that have been bifurcated from the host contract, on the consolidated statements of operations.


	Amount of gain (loss) recognized in
	net income on derivatives for the
	year ended December 31,
Derivatives not designated as hedging instruments	2018		2017		2016
	(in millions)
Interest rate contracts	$	(27.6)	$	(26.9)	$	243.3
Foreign exchange contracts		(64.2)		59.4		20.1
Equity contracts		(31.0)		(181.3)		(123.5)
Credit contracts		(1.6)		(15.9)		37.4
Other contracts		108.5		11.5		(4.8)
Total	$	(15.9)	$	(153.2)	$	172.5